On 20 May 2013, HM Revenue & Customs (“HMRC”) issued a consultation document on two areas of perceived tax avoidance involving the use of Limited Liability Partnerships (“LLPs”) and mixed partnerships.  The consultation closed on 9 August but it was not until 10 December 2013 that draft legislation was released and, despite the call for clarity and certainty in the new legislation, many firms may well need to rely on HMRC not challenging their arrangements on the grounds of materiality when it comes to agreeing how the new rules should apply.

LLPs – Disguised remuneration

The first area of perceived abuse involves the use of LLPs, with employers transferring sections of their work force into LLPs running alongside the existing business, with the transferred employees becoming members of the LLP, earning a fixed salary.  An alternative arrangement popular with professional partnerships was to convert the business into an LLP and for a number of senior employees to become members, taking fixed profit shares.

Section 863 of the Income Tax (Trading and Other Income) Act 2005 provides that all members of an LLP are to be partners, which has allowed members who would otherwise have been regarded as employees for tax purposes to be taxed under the more favourable rules as self employed individuals.

This arrangement saves employer’s national insurance contributions (“NIC”) and the savings here can be considerable.  In many cases, these savings will be shared with the workers.  A worker on £75,000 a year, for example, costs an employer almost £10,000 in NICs:  multiply that by 10 workers and the savings add up to almost £100,000.

This is one of the reasons why LLPs have become so popular, not only with a number of large professional partnerships, but also with other industry sectors, where no one would reasonably consider that the workers are anything but employees had it not been for Section 863.

The draft legislation introduces a number of conditions, where at least one needs to be met in order for a fixed profit sharing member to be treated as self employed for tax purposes, and these are discussed in more detail below.

The new rules will apply from 6 April 2014 and so now is the time for all businesses, regardless of their year end, to carefully consider how the new rules will affect them, or they run the risk of certain members losing their preferential self employed tax status for 2014/15 onwards.

Mixed Partnerships and LLPs

The second area of perceived abuse is the use of mixed partnerships and LLPs to move profits and losses between individual and corporate partners (in which the individual partners or their family might have an interest) in order to benefit from lower rates of tax on profits and higher rates of tax relief on losses.

We will not be looking at this area further in this brief other than advising that anti avoidance legislation was introduced with effect from the Autumn Statement date of 5 December, with further detail being released on 10 December 2013.


Members of an LLP are currently automatically taxed as self employed persons.  However, the draft legislation sets out three conditions that, if all met, will mean that the individual will be taxed as an employee from 2014/15.  You therefore need to fail one of the tests to be taxed as a self employed person.

We have rephrased the conditions for the purposes of this brief and have couched them in terms of you having to satisfy at least one of the conditions in order to retain your self employed status instead, which should help firms consider what arrangements, if any, should change in order to prevent a reclassification.

Condition A – Disguised Salary

The member’s fixed profit share entitlement must not be substantial.  “Substantial” is not defined but the guidance notes indicate that the fixed profit share element must not be more than 80% of their “reasonably expected” profit share, so in other words, any variable amount must be at least 20% in order for the individual to retain self employed status.

Condition B – Significant Influence

If a member can demonstrate that he has a significant influence over the affairs of the LLP, the individual will retain self employed status.  “Significant influence” is not defined but the guidance provides some examples which we will look at in more detail later.

Condition C – Contribution

Finally, if a member makes a capital contribution to the business of at least 25% of the amount of fixed profit share “reasonable expected” by the member, he will have demonstrated that he has significant capital at risk in the business and so will continue to be treated as being self employed for tax purposes.

The conditions are meant to require the individual members to demonstrate that they are subject to the normal risks and benefits that come from being in partnership such as:

  • Profit shares being dependant on the results of the business each year;
  • Being involved in the strategic decisions of the business; and
  • Having a reasonable amount of capital at stake, should the business fail.

Only one of these conditions need to be met in order to satisfy the self employment requirements and it is important that businesses review the position now to see if any members are at risk and, if so, which conditions may reasonably be met, which align the individual’s desires with the business requirements of the LLP.


Your LLP may well have a number of individuals who will be reclassified as employees under the new rules from 2014/15 onwards.  If you do not review the position now and come up with a mutually agreeable solution, those individuals will become employees for tax purposes, with employer’s NIC costs having to be added to profit shares as well as the timing of tax payments changing from twice yearly to throughout the year via the payroll.

Because of the increased NIC cost, you will need to agree with the individual who will bear the additional cost but, given most employers shared the NIC savings when converting to an LLP, it would not be unreasonable for the costs to be shared, meaning individuals will see net income falling.  The Salaried Member may also be in receipt of taxable benefits for the first time and these costs will also need to be considered.

If individuals are to be reclassified for tax purposes, the LLP might also decide to reclassify them as employees for other purposes, effectively demoting them from member to employee status.  You will need to consider carefully how this will be communicated to the individuals concerned and it may well drive individuals to leave the business, which may not be desirable.

Other factors will also need to be considered such as removing names from PII policies; amending the list of members at the registered office; changing VAT registrations; removing the individual from the partnership tax return and changing authorised cheque signatories.


However, provided at least one of the conditions is met, the fixed profit share partner will continue to be treated as self employed for tax purposes and so we will now look at each of the conditions in more detail.

These tests apply to members who are members at 6 April 2014, but not to corporate members or individuals who do no more than invest in the LLP.

The Conditions

Condition A – Disguised Salary

This condition looks at how the individual is rewarded for his performance in the business and is regarded as being the most significant test per HMRC’s guidance notes.  Provided the individual’s reward (profit entitlement) includes an element whereby at least 20% of his “reasonably expected” share is linked to the performance of the business as a whole, he will be regarded as self employed. The 20% reference is not included in the definition of disguised salary and is only HMRC’s interpretation of what is or is not substantial.

At least 20% of the profit share should be variable and this is measured against profits that are reasonably expected, which is a subjective test.  However, fixed shares will include fixed amounts such as salaries, guaranteed amounts or amounts paid in respect of the individual’s or part of the business’ performance, such as bonuses, not linked to the performance of the firm as a whole.


Example 1:  J is a member of Osborne LLP.  He will receive a salary of £100K plus a bonus to be decided on by the remuneration committee at their discretion.

The guidance states further information is needed here to consider the real extent of the discretion and the likelihood of any bonus being at least £25K or more in order for at least 20% of J’s reward to be variable.

Example 2:  P is also a member of Osborne LLP.  He is entitled to a fixed salary of £50K plus 20% of the profits after salaries.  Historically, this has given him a further £20 – £30K each year.

P’s variable element dependant on the performance of the business as a whole is between 29% and 37.5% of his overall package and so as more than 20% is variable, he will be self employed.

Example 3:   S is a member of Cameron LLP and can draw £10K per month as drawings, in advance of his profit share.  If the profit share is not sufficient, he will need to repay money to the LLP.  If his profit share ends up exceeding £120K, he will receive a further payment.

S’s profit share is entirely variable and so will satisfy Condition A.

Example 4:   T is a member of Cameron LLP and is entitled to a fixed share of £50K plus 10% of any profits over £1 million.  The LLP normally makes profits of about £200K and so T will never realistically receive any variable amount.  T’s £50K is disguised salary and Condition A is not met.

The test will apply to how realistic the allocations are at the time of the profit share agreement, and although will not be retrospective, will mean a review of historical past performance may be necessary.  It is therefore important to document profit sharing arrangements with supporting business projections, prepared on a realistic basis and possibly by your accountant, and to not consider this condition with the benefit of hindsight.

The guidance notes say the starting point will be looking at the LLP agreement together with any side agreements, and so it is vital that these documents reflect the correct position.

Condition B – Significant Influence

This condition looks at the role played in the LLP by the individual and whether it can be said that he is involved in the running of the business as a whole, or whether he is merely an employee.

“Significant influence” is not defined and so again will be subjective.  However the guidance suggests that this test will not be met in large LLPs, where control has been delegated to a management committee, or where the individual only attends an annual meeting or has influence over only part of the business, such as department or particular office.

The guidance refers to a three partner LLP where each member is regarded as having a significant influence despite no one person actually being able to control the business, and also to large LLPs as set out above where only the management committee has significant influence.

It is not clear however how this will apply to firms with say between 5 and 15 members which may have a management committee for making day to day decisions but where more important strategic decisions are still voted on by all members.

Whilst it is our view that each member would have a significant influence, this could be challenged by HMRC and so it will be important that the LLP agreement requires strategic decisions to be voted on and that meetings are being held regularly, with evidence being available to support any decisions made.  In our opinion, significant influence should relate to decisions which would never be passed to employees of the firm to make, rather than to day to day matters which could easily be delegated to senior managers.

It is also possible that HMRC will not be interested in firms of this size given the consultation intended to impact on large professional partnerships and anticipated that the majority of partnerships would be unaffected.

Condition C – Contribution

This test looks at the amount of capital a member has at risk in the business.  Members may already have retained profits in the business, for example tax reserves or current accounts, but these are not at the same risk should the business fail as a capital account would be.

The test is whether the member has capital invested in the business of at least 25% of any fixed profit entitlement.  If he does, he will be self employed for tax purposes.

This test is considered on 6 April each year, starting with 6 April 2014.  It is applied again where there is a change in the capital contribution and is made in reference to the amount of capital the individual is required to make and does make under the LLP agreement.  Future capital requirements and undrawn profits are ignored, unless the undrawn profits are to be converted to capital by agreement.  Tax accounts are ignored as are any sums contributed where the intention is to help overcome the new rules rather than being held in such a way as to put the sums at risk.


Example 5:  J has a fixed profit share of £100K and a tax reserve account of £25K.  He does not therefore have any capital in the business and so fails this test.

Example 6:  P has a fixed profit share of £50K plus 20% of profits after salaries.  This normally gives him a further £20K – £30K.  He also has a capital contribution of £10K.  The test is applied in respect of his fixed entitlement and is therefore only a 20% contribution and therefore fails this test.  If his capital was increased to £12,500, he would pass the test and continue to be self employed.


Anti avoidance rules have been introduced to prevent any arrangements put in place from being effective where the main purpose is to avoid the Salaried Member rules from applying.  Genuine commercial arrangements will not be affected and so, if for example, capital in introduced into the business, this has to remain in the business for the long term.

Further anti avoidance means that if an individual operates through a corporate partner, rather than as an individual partner, the individual will be taxed as an employee.  This only applies though where the main purpose or one of the main purposes of operating through the corporate partner is to avoid the Salaried Partner rules from applying.


All firms with members who receive any element of fixed profit entitlement need to consider how the new rules will affect all members from 6 April 2014.  This needs to be looked at now as time will be needed to discuss the potential impact and any proposed plans to prevent the rules from applying.

The choice is then to either do nothing, as set out above, or to consider commercially whether any of the conditions can or should be met.  For example, for large firms, it may not be practical or desirable to have all members involved in the running of the business and so the significant influence test will not be met.

Alternatively, it might be desirable to require all members to inject capital of at least 20% of fixed profit shares, which would help the firm in terms of funding, although care would need to be taken in not breaching lending terms.

This would need to be agreed by the members as capital would then be at risk, but this risk might be acceptable when viewed in terms of the increased costs associated with being taxed as an employee and the interest that could be earned from the LLP on the capital injection.  However, fixed profit share partners might also expect a higher profit share to compensate for the either partial or full conversion to equity partner.

Finally, fixed profit shares could be replaced with variable shares.  However, full equity partners could see their own profit shares falling in good years and so careful planning will be required here.

All of these changes will need to be reflected in the LLP agreement, which can be costly and time consuming.  The changes will also affect all partners, not just the ones directly affected by the legislation, in terms of potential additional costs or changes in arrangements and so deserves careful consideration.

If you are concerned about any aspect of the proposals and how these will impact on your business, please contact us.

It is important to note that the legislation released on 10 December is in draft format only and will not become final under Royal Assent in granted in July 2014.  However, HMRC’s Technical Note and Guidance issued with the legislation states that the Government would not expect to make any significant changes to the published legislation.

Get started today

Contact us today and speak to our expert team to get started

close slider